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Currencies are a good portfolio diversifier

As equity markets have raced ahead in January, a diversification strategy may not be top of every investor’s list of priorities.

However, if the fiscal cliff negotiations do not go to plan, or the European crisis rears its head once again, investors may resume their hunt for non-correlated asset classes. Of these, currency funds are an increasingly popular option.

Currency markets remain one of the few places investors can make money in all environments simply because they trade relative rather than absolute value. A good manager should, in theory, be consistently on the right side of the trade. Of course, it also means that a bad currency manager won’t be rescued by bullish markets in the same way as a bad equity manager might.

Investec, Pictet, Insight and Schroders all have dedicated currency funds. There are also some hybrid currency and fixed interest funds, such as the Tideway Global Navigator fund. Some are generalist funds, trying to make money by taking long-term positions on different currencies, others may specialise in niche areas such as emerging markets. Some currency hedge funds use a quantitative approach, looking at chart analysis and a currency’s historic trading range and ‘real-world’ exchange rates, such as the price of a McDonald’s burger in different countries.

Performance, as might be expected, is varied. The top fund in the offshore ‘currency other’ sector is the UBS (LUX) Money Market fund, up 23 per cent in five years. Sanlam Global Liquidity is at the bottom, having lost 4.6 per cent in the same period. The FE risk scores vary between 50 and 70, compared with more than 100 for most UK All Companies funds.

Thanos Papasavvas, a strategist in the fixed income and currency team at Investec, says that currencies are driven by fundamentals – a country’s underlying interest rate, economic situation, trade balance and similar metrics – and valuations, whether a currency looks cheap or expensive: “The recent moves in the euro, for example, have not been about fundamentals, which remain poor, but it was driven higher because everyone was either underweight or short of the euro.”

He says under or overweight positions in the Investec funds are determined by relative value – Malaysia versus India, for example.

Henry Lancaster, senior investment analyst at Coutts, says that currency investors are particularly sensitive to interest rate differentials: “That said, investors must take into account all the economic and other news that might affect the long-term attraction of a currency as an investment destination. So markets pay particular attention to the economic and political stability that underpins a currency’s creditworthiness.

“The appetite for risk among investors is a key determinant of the net flows into currencies deemed ‘safe havens’, such as the US dollar and Swiss franc, compared with investment in higher growth potential areas, such as emerging economies.”

Mr Papasavvas argues currency investing can be profitable because currencies may trade away from their fair value for long periods of time. As such, active managers should be able to deliver good returns by exploiting these imbalances. However, whether they succeed in practice comes down to the skill of the manager.